Weekly Commentary Overview
- U.S. equities finished in the red last week. Large U.S. companies continue to struggle with the competitive headwind caused by a stronger dollar.
- Curiously though, small caps, which have lower exposure to international sales, are not benefiting.
- In contrast to U.S. equity markets' flat performance, Japanese and European stocks continue to advance .
- On the bond side, U.S. economic data remain mixed, but strong enough for investors increasingly to assume the Federal Reserve (Fed) will raise interest rates this fall.
- Those expectations are leading to what's known as a flattening of the yield curve, whereby shorter-term bond yields rise faster than yields on longer-term bonds, as the former sell off.
- Accordingly, we continue to believe long-term yields will remain contained, but shorter-term bonds remain vulnerable.
U.S. Stocks Decline as the Dollar Impacts Earnings
U.S. equities finished in the red last week. The Dow Jones Industrial Average fell 1.79% to 17,373, the S&P 500 Index slipped 1.28% to 2,077 and the tech-heavy Nasdaq Composite Index dropped 1.66% to close the week at 5,043. Meanwhile, the yield on the 10-year Treasury fell from 2.20% to 2.17%, as its price correspondingly rose.
Large U.S. companies continue to struggle with the competitive headwind caused by a stronger dollar. Curiously though, small caps, which have lower exposure to international sales, are not benefiting. On the bond side, U.S. economic data remain mixed, but strong enough for investors increasingly to assume the Federal Reserve (Fed) will raise interest rates this fall. Those expectations are leading to what’s known as a flattening of the yield curve, whereby shorter-term bond yields rise faster than yields on longer-term bonds, as the former sell off. Accordingly, we continue to believe long-term yields will remain contained, but shorter-term bonds remain vulnerable.
No Solace in Small Caps
In the U.S., earnings season has been better than expected, but lower estimates of third quarter earnings are keeping a lid on any gains in stocks. Equities were also hurt by several companies, including Disney and Sears, failing to meet earnings expectations. So far this year, the S&P 500 Index is struggling to hold onto a 1% gain, while the Dow Industrials and Transport indexes are now solidly in negative territory year-to-date.
Overall, however, the second quarter was not the earnings disaster some had expected, but it has failed to inspire investors. Sales were down 4% year-over-year, while earnings grew by 1.5%; excluding energy, that figure jumps to 9.3%. While low rates and sluggish wage growth allowed profit margins to remain at record levels, a strong dollar has hurt companies’ revenues.
Many investors have been favoring small-cap stocks, which depend less on international sales than larger companies, in an effort to mitigate the impact of a stronger dollar. But the strategy has not provided much benefit. The large-cap S&P 500’s modest 1% gain is slightly ahead of the small-cap Russell 2000 year-to-date.
What exactly is holding back small caps? While they do have less exposure to international sales, small cap stocks have proved more vulnerable to rising real interest rates (the interest rate after inflation) and investor anticipation of monetary tightening. The vulnerability was reinforced during earnings season as investors worried about the impact of a flattening yield curve on small cap banks, which make up roughly 25% of the Russell 2000. In July, the trailing price-to-earnings ratio for the Russell 2000 contracted by roughly 2%, while the S&P 500 gains were supported by multiple expansion of roughly 2%. Accordingly, we would remain neutral in terms of any size bias in U.S. equities.
In contrast to U.S. equity markets’ flat performance, Japanese and European stocks continue to advance. Part of the reason stems from divergent monetary policies and anxiety in the U.S. over a pending Fed rate hike. However, perhaps a bigger reason is earnings.
As U.S. companies eke out nominal gains, thanks mostly to sky-high profit margins, companies in Europe and Japan are enjoying solid earnings and revenue growth. In Europe, earnings per share growth is up 14% year-over-year, and is even higher ex-energy. The weaker euro has been one factor supporting top-line growth, the exact opposite of what we’re seeing in the United States.
Many investors have been favoring small-cap stocks, which depend less on international sales than larger companies, in an effort to mitigate the impact of a stronger dollar. But the strategy has not provided much benefit.
Ready, Set … Rate Hike?
While a soft ISM manufacturing report provided more evidence of the strong-dollar headwind, most of last week’s data confirmed our view that the economy in the second half of the year should be an improvement over the first half. The ISM non-manufacturing survey showed the services sector expanding at the fastest pace in a decade. And the July non-farm payroll report released Friday showed job growth remaining well in excess of 200,000/month, even while wages and the labor participation rate remain stuck.
Despite the lack of wage growth, there is a growing perception that the economy is strong enough to begin removing the ultra-accommodative conditions that have defined U.S. monetary policy since 2008. Last week’s solid jobs data as well as comments from Atlanta Fed President Lockhart served to heighten expectations for a September rate hike. As a result, two-year Treasury yields climbed back toward 0.75% even as 10-year yields remained stuck at around 2.17%, exactly where they started the year.
We still believe structural factors are likely to keep movements in longer-term bonds relatively contained, but investors should remain cautious on the short end of the yield curve. Also, while municipal bond flows have been negative recently amid Puerto Rico-related angst, we continue to believe attractive relative yields and improving credit conditions favor the broad muni space relative to Treasuries.
